Issues 2016

January 8 – CNBC (Ritika Shah): “Billionaire investor Mark Cuban is ‘doing nothing’ about the market sell-off. In his latest note to his ‘dusters’—a term for users of the Cyber Dust app that he advises and funds—Cuban revealed his investment strategy. ‘While all the selling seems to be based on China and the price of oil, I really don’t know what the long term implications for our stock market is,’ he wrote… ‘So I follow the number one rule of investing. When you don’t know what to do. Do nothing.’”

It’s being called the worst start for global securities markets ever. The Shanghai Composite was down a quick 10% this week. Japan’s Nikkei sank 7.0%. Hong Kong’s financial index dropped 8.7%. Germany’s (investor “darling”) DAX equities index was slammed for 8.3%. Here at home, the S&P fell a relatively moderate 6.0%. Biotechs sank 10%. Gloomily, the financials (banks and broker/dealers) were down almost double-digits. The small caps were hit for 8%. The Nasdaq100 fell 7%. “FANG” was defanged.

Credit spreads widened across the board. With “money” flowing out of bond funds, even top-tier bonds are now feeling the effects. Investment-grade spreads widened this week to a three-year high. It was another tough week for high-risk corporate debt.

Currency markets commenced the year in disarray. The yen jumped 2.7% against the dollar, surpassing August tumult-period highs. Borrowing in cheap yen to finance leveraged holdings in higher-yielding currencies was a fiasco. The Australian and New Zealand dollars were down almost 5%. Some key EM currencies were under intense pressure. The Mexican peso fell 3.9%, the South African rand 4.8%, the Russian ruble 3.1%, the Turkish lira 3.6%, the Chilean peso 2.9%, the Colombian peso 2.9%, the Singapore dollar 2.4% and the Malaysian ringgit 2.3%. China’s yuan declined 1.6% against the dollar.

It was an ominous beginning to what is poised to be a most tumultuous year. Market participants are quickly coming to appreciate that China does in fact matter. Few understand why. Most – from billionaires to fund managers to retail investors – will “Do Nothing.” This has worked just fine in the past – repeatedly. Not understanding and not doing anything will be detriments going forward.

Analysts will point to Friday’s surge in non-farm payrolls as evidence of the underlying health of the U.S. economy. There’s a strong consensus that U.S. markets have been greatly overreacting to risks posed by China and the global slowdown. Popular sentiment was captured well in a Friday headline: “Market meltdown can be read as giant ‘buy’ signal”

Back in 2000, I titled a presentation (and CBB) “How Could Irving Fisher Have Been So Wrong?” From Wikipedia: “The stock market crash of 1929 and the subsequent Great Depression cost Fisher much of his personal wealth and academic reputation. He famously predicted, three days before the crash, ‘Stock prices have reached what looks like a permanently high plateau.’ Irving Fisher stated on October 21 that the market was ‘only shaking out of the lunatic fringe’ and went on to explain why he felt the prices still had not caught up with their real value and should go much higher.”

Fisher, one of America’s most accomplished economists, was in 1929 operating with a deeply flawed analytical framework. And for years leading up to the crash the optimists had been repeatedly emboldened, as a booming stock market confirmed their view of the world. Fisher and the world were then completely blindsided. Their views of how the economy, the securities markets, policymaking and Credit interacted were completely erroneous. I expect some resolution of competing analytical frameworks to be a key Issue 2016.

Today’s conventional view holds that the underlying fundamentals supporting the U.S. economy are healthy. In general, markets are driven by fundamentals. Finance is sound. China, commodities and a downshift in global growth are temporary setbacks ensuring ongoing ultra-loose monetary policies. U.S. markets will soon look beyond negatives, as focus returns to long-term favorable prospects for growth, corporate profits and inflation.

An opposing analytical framework, one to which I subscribe, is focused foremost on finance – in particular the system of securities-based Credit and securities that over the past thirty years rose to world dominance. Regrettably, this “system” is deeply flawed and today acutely unstable. In short, global “money” and Credit are structurally unsound. In general, and especially late in this era, market-based finance drives economies. Unprecedented central bank monetization and market manipulation have inflated securities markets along with underlying fundamentals (corporate cash flows/profits, incomes, household perceived wealth and GDP).

Why is China today so critical to global markets – including those in the U.S.? The bulls argue that a Chinese slowdown will have minimal impact on U.S. corporate profits. The harsh reality is that Chinese financial and economic crisis has the potential to push an already fragile global financial “system” over the edge. From the perspective of my analytical framework, the historic “global government finance Bubble” is faltering and will not survive a China bust.

As they say, “bull markets create genius” (unless you’re an analyst of Credit and Bubbles). And there’s also a reason they’re called “virtuous cycles” – though there’s nothing virtuous about Bubbles. But they sure look good and feel good – and inspire over-confidence (along with dreams and inflated ambitions). Things just seem to go right during booms. And it wasn’t long ago that the conventional view held that Brazil, after all these years, finally got it right. Brazilian politicians, central bankers, businessmen – and the nation’s economy – were held in high regard. Talk today is of corruption, inflation, depression, impeachment and mayhem. The Bubble burst and genius was in short order transformed to gross Incompetence.

For years (decades), China was perceived to be doing all the right things. Their system of disciplined meritocracy ensured the best and brightest were in command of one of the greatest economic miracles (and enterprising and hard-working populations) the world has ever known. Today, history’s most spectacular Bubble is bursting. Genius has so rapidly morphed into Incompetence. When Bubbles burst – and confidence turns to angst – it’s as if suddenly nothing can go right. Dwarfing even the Japanese experience, it’s astounding how decades of accomplishment have been sabotaged by seven years of runaway Bubble excess.

This is not Mexico 1995, Thailand 1997, Russia 1998, nor even Europe 2012. Approaching $35 TN (from ~$8TN in 2008), the Chinese banking system over recent years has ballooned to almost double the size of that of the U.S. In terms of economic output, China rivals the U.S. As a global hub for manufacturing, they have few rivals. And if global financial and economic ramifications were not troubling enough, there is an alarming geopolitical component to the unfolding China bust. The Chinese boom has tremendously inflated perceived wealth right along with expectations. The Chinese people do not have a ballot box. Beijing will blame foreigners, especially the U.S. and Japan. China is a most critical Issue 2016 – and fight off the calls to downplay its maladies and significance.

A Friday headline from the Financial Times: “China steps up capital controls to stem outflows – Queues form outside Shenzhen banks as regulator orders them to limit clients’ dollar buying”

China policymakers today face a dire circumstance. Chinese international reserves dropped a record $108 billion in December to $3.33 Trillion (down almost $700bn in 12 months). The year ago $4.0 TN (and growing) reserve war chest was viewed as sufficient to placate growing international concerns for the soundness of China’s economy and the underlying finance underpinning the boom. Massive reserve holdings surely bolstered Beijing’s own confidence that ample resources were available to ensure system stability, as they moved forward with economic reform and structural adjustment.

Now, as the bursting Bubble phase gathers momentum, China’s reserves provide a crumbling foundation for confidence – internationally as well as domestically. Chinese officials might now seek to orchestrate a major currency devaluation and system reflation (comparable to past moves by the U.S., Japan and Europe). But they will face the traditional EM problem of flagging confidence – in their currency, in their banking and financial systems, in their economic structure and in policymaking. They risk further inciting destabilizing outflows – and the more aggressive Chinese fiscal and monetary stimulus the more precarious the “capital” flight issue will become.

It was always my view that there was an unappreciated downside to the inflating Chinese reserve position. There was evidence and anecdotes of enormous “capital” flight out of China (corrupt “money” as well as the affluent seeking safety). Yet these outflows were overwhelmed by massive “investment” inflows. I long suspected that huge – potentially unprecedented – “hot money” flows were being attracted by China’s high yields (i.e. corporate bonds and “shadow banking” instruments).

I believe we’re now seeing a highly destabilizing scenario unfold, where faltering financial and economic Bubbles spur de-leveraging and flight out of Chinese financial assets. At the same time, Chinese companies that issued huge amount of dollar-denominated debt are these days scurrying to accumulate dollars. Moreover, Chinese households – having accumulated Trillions of deposits and other financial claims – would today prefer to diversify some of their newfound wealth out of the depreciating yuan.

Do Chinese officials continue to expend national wealth (international reserves) to accommodate flight out of China (at top dollar)? Not many months ago Putin decided it was not in Russia’s interest to rapidly burn through the nation’s international reserve holdings.

January 7 – Under the Reuters’ headline, “Sources: China wants quick, sharp currency decline.” “China’s central bank is under increasing pressure from policy advisers to let the yuan currency fall quickly and sharply, by as much as 10-15%, as its recent gradual softening is thought to be doing more harm than good. The People’s Bank of China (PBOC) has spent billions of dollars buying yuan over recent months to defend the exchange rate, but has failed to stabilize market sentiment… That gradual, managed depreciation makes the yuan a one-way bet for investors who see the currency weaken even as the central bank intervenes to prop it up. Policy insiders are now calling for a quick and sharp yuan depreciation, backed by tighter capital controls to curb speculation and the flight of money out of the country.”

I’ll throw out some thoughts: In general, I expect so-called “price anomalies” and dislocation to be an Issue 2016 for derivatives and securities markets generally. The course of China’s currency regime shift could easily turn disorderly, spurring dislocation and illiquidity in various markets. At the same time, markets could dislocate as various currency “carry trades” unravel – certainly including what I suspect is massive embedded leverage in the yen “carry trade.” The probabilities are also substantial that EM markets could dislocate on the fear of unmanageable dollar-denominated debt. A system-wide de-leveraging episode is possible. I would argue that there has never been such a risky global backdrop with a confluence of major market fault lines.

My analysis has focused on the proliferation of leveraged strategies, speculative excess and the Crowded Trade phenomenon. For seven years now, the Fed and global central banks have inflated global securities markets with Trillions of new “money.” This “money” – along with central bank manipulation and liquidity backstops – over time effectively destroyed the normal functioning of the marketplace. Excesses were allowed to grow and become deeply embedded. And, importantly, the aberrant market backdrop worked to the disadvantage of active management relative to the indexes. Last year saw further exodus from active (to passive) management work generally to exacerbate the travails of active fund management, especially for more sophisticated “long/short,” “quant” and “risk parity” strategies.

The upshot has been, in the face of a faltering global Bubble, “money” continuing to rush into the “market” through index ETFs and similar products. According to Blackrock, $347 billion flowed into ETFs globally in 2015 to surpass $3.0 TN. Almost matching 2014’s $246 billion, another $228 billion made its way to U.S. ETFs last year. This is “money” speculating on the market, in contrast to investing in a savvy manager, a sound investment strategy or in company/industry fundamentals. Chiefly, it’s one historic bet on the conventional bullish view and faith in the ongoing genius of central bankers. This “hot money” and is now at high-risk for a destabilizing rush to the exits.

I have serious issues with the underlying structure of U.S. and global financial markets that I expect to emerge in 2016. The biggest losses since the financial crisis come with bullishness and complacency deeply entrenched. It is not easy at this point to envisage the buyers who will let the ETF crowd unwind their bullish positions. It’s not obvious how markets remain liquid in the event that the leveraged speculative community is hit with large redemptions. And I have no idea how confidence in the multi-hundreds of Trillions derivatives marketplace holds when the markets begin to seize up.

And it again comes back to competing analytical frameworks. China doesn’t look all too problematic from the perspective that views the U.S. economy as healthy; U.S. finance as sound; that corporate profits and GDP will continue their long-term upward trends; and that the astute Federal Reserve has things well under control. But from the perspective of seven years of the most egregious monetary inflation in history – the “Terminal Phase” of an unprecedented multi-decade global Credit Bubble – fueling the biggest global securities Bubble in history, with history’s greatest worldwide speculative excess and most precarious economic maladjustment and imbalances ever – well, China provides a dangerous Bubble-piercing catalyst.

I expect 2016 to see some resolution to the unprecedented divergence between inflated global securities markets and deflating fundamental prospects. Portending acute economic vulnerability, faltering markets will see a tightening of financial conditions and vanishing perceived wealth. Confidence will wane – confidence in the markets, in the economy and in policymaking. It will surely make for a wild election cycle. It will also ensure a high-risk geopolitical backdrop. I expect less rate “normalization” and more QE.

Drawing from my “Core vs. Periphery” analytical framework: De-risking/de-leveraging at the “Periphery” is problematic with the potential for expanding risk aversion to exert contagion effects toward the “Core.” I’ll posit that de-risking/de-leveraging at the “Core” pushes a fragile system right back to financial crisis. As such, the first week of 2016 supports the view of a vulnerable “Core.” U.S. stocks have succumbed to “risk off.” Attention now turns to a critical Issue 2016: The soundness of U.S. and global corporate Credit.

Over recent Bubble years, incredible quantities of “money” have flowed freely into U.S. Credit. Central bank policies have ensured epic mispricing throughout U.S. and global fixed income and derivatives markets. Buyers of U.S. securities and derivatives have been willing to tolerate skinny little returns on the view that the Fed ensured minimal risk. The Fed and global central bankers readily nurtured the perception of low risk throughout global securities and derivative markets – the “Moneyness of Risk Assets.”

There’s always a vulnerability associated with money – and “Moneyness”: crises of confidence are inherently highly destabilizing. There’s a shock when holders of perceived risk-free “money”/securities/derivatives come to realize their previous misperception. As confidence in both economic fundamentals and central banking wanes, I expect already problematic fund outflows to accelerate. A tightening of financial conditions portends Credit problems way beyond energy and mining. I hope I am much too dire. Acute systemic risk on a global basis is The Big Issue 2016.